Introductory Guide to Japan ETF Investing

The Japanese economy – which collapsed following the disastrous earthquake and tsunami in March 2011 as well as a long-drawn deflation – heaved a sigh of relief in 2013 when Prime Minister Shinzo Abe introduced 'Abenomics' – a monetary and fiscal firepower (read: Japan ETFs: One Year After Abenomics).

Drastic monetary easing to maintain a target inflation rate of 2% within two years, flexible fiscal policy and structural reforms made Japan a high flier last year as indicated by the 50% return delivered by the benchmark Japanese index, the Nikkei – the best yearly performance in more than 40 years for the key Japanese benchmark.

Bank of Japan introduced monetary stimulus measures last April. The bank follows a policy of increasing Japan’s monetary base at an annual run of about 60–70 trillion yen. For Japan, these measures were welcome steps as the economy has been marred by weak growth and low inflation levels for more than a decade.

However, despite such easing, the economy has failed to sustain the winning momentum for a host of reasons. Strength in the yen in the face of prolonged geo-political concerns, sales tax hikes and falling inflation have posed obstructions to the growth path of late. Let’s dig a little deeper into what has been impacted the Japanese economy as of late:

Shrink in GDP in Q2, Strength in Yen, Sluggish Export

Having bettered analysts’ expectation in Q1 and grown an annualized rate of 6.7%, Japan’s GDP fell an annualized 6.8% in Q2 indicating the most awful retrenchment since 2011 hurt by a sales tax hike which took a bite out of consumers’ big ticket purchases. However, the decline in GDP was lower than a market forecast of a 7.1% drop.

Private consumption, which makes up about 60% of the economy (per Tradingeconomics), contracted 5% as households cut on spending after a hike in sales tax to 8% from 5% from April 1^st. Notably, Japan witnessed front-end loaded consumption demand prior to the tax hike which clearly explains the sluggishness in the present demand profile.

Private residential investment plunged about 10.3% and imports fell 5.6%. Exports too dipped 0.2% in the quarter probably hurt by low foreign demand and a 2% rise in the yen relative to the greenback during Q2. Relentless geo-political tension led the safe haven Japanese currency to appreciate during this time frame. Otherwise, Japan has been a big beneficiary of weaker yen thanks to extreme policy easing.

However, the most troublesome part was that the country’s trade balance was in the red each month for the last two years as import growth was faster than that of exports. A pickup in exports in the last 1.5 years in the wake of a weaker yen failed to generate a trade surplus.

In July, the nation posted larger-than-expected deficit of Y964 billion ($9.3 billion). Actually, import of fuel to make up for the collapse of its nuclear power industry continues to hurt the trade balance (read: Japan ETFs in Focus as BOJ Boosts Loan Programs).

To reflect the wavering economic scenario, Japan reduced its growth target for fiscal 2014 from 1.1% to 1% in July. However, growth projections for fiscal 2015 and 2016 were kept untouched. Debt burden is also a bother for Japan. While the flush of liquidity has given equities a solid boost, it put a strain on Japan’s fiscal heath, with public debt over 230% of the country’s GDP.

Brighter Spots

Japan’s annual inflation rate touched the 23-year high in May which was a sheer reflection of a sales tax hike. Though the rate declined to 3.6% in June from 3.7% in May and is expected to show a softer trend as the tax hike effect subsides, the rate should hover around BOJ’s targeted level of 2% in the coming months.

The BOJ estimates the sales tax rise to add 2.0 points to annual consumer inflation from May onward. The bank also expects the consumer price index (CPI) at 2.6% for fiscal 2015 and to reach 2.8% in fiscal 2016.

Japan's joblessness rate plunged to the 16-year low in May, indicating a tightening in the labor market and a rebound in the economy. However, the rate increased to 3.7% in June from 3.5% in the previous month, but the underlying trend seems intact.

What Lies Ahead?

Though geo-politics are playing a role in controlling the movement of yen, a differently directed monetary policy in the U.S. and Japan – U.S. is steadily withdrawing monetary stimulus while Japan is maintaining the policy – will not let the currency gain more strength. This will help Japanese companies operating abroad such as Toyota Motor Corp. (TM) and Honda Motor Co Ltd (HMC) in repatriating more money earned in dollar terms.

We believe Japan’s economic conditions are stronger relative to several other developed countries, compelling investors to play there over the other markets. However, currency concerns might come in the way of Japan investing.

A weaker currency has made it vital for investors seeking Japanese holdings in their portfolio to invest in hedged equity ETFs, and we have highlighted two such funds below. Beyond that though, if you believe that the yen will see strength, we have also taken a closer look at some of the more popular ‘regular’ Japanese funds on the market as well:

WisdomTree Japan Hedged Equity Fund (DXJ)

DXJ has been designed to provide a hedge against currency exposure. DXJ invests about $10 billion in 304 stocks. Toyota Motor (4.95%), Mitsubishi UFJ Financial Group (4.82%) and Japan Tobacco (3.91%) are the top three choices of the fund.

In terms of sectors, Consumer Discretionary dominates the holding pattern while Industrials, Information Technology and Financials also get double-digit allocation in the fund. The fund charges a fee of 48 basis points on an annual basis. Though DXJ is almost flat so far this year, it has added about 14% in the last one year. DXJ has a Zacks ETF Rank #1 (Strong Buy) with a Medium risk outlook.

db-X MSCI Japan Currency-Hedged Equity Fund (DBJP)

DBJP tracks the MSCI Japan US Dollar Hedged Index, which provides exposure to Japanese equity markets and hedges the Japanese yen to the U.S. dollar by selling Japanese yen forwards.

However, DBJP does not appear to be as popular as DXJ having amassed about $543 million in assets. DBJP gives exposure to about 300 securities. The fund is still somewhat concentrated from a sector perspective. Consumer discretionary, industrials and financials comprise more than three-fifth of the total assets each taking more-or-less one-fifth of the basket.

The fund charges 45 bps in fees. DBJP has lost about 2.65% from a year-to-date look thanks to a strengthening yen during this time frame. The fund’s one-year return remains decent at 13.6%. DBJP has a Zacks ETF Rank #2 (Buy) with a moderate risk outlook (read: Inside The Top Ranked Japan Hedged Equity ETF).

iShares MSCI Japan Index Fund (EWJ)

The fund is the oldest and most popular ETF tracking the Japanese market. EWJ offers liquidity to investors with a trading volume of more than 23 million shares a day. The fund invests about $15 billion in assets in a large basket of 308 Japanese stocks. The fund invests a quarter of its asset base in these top holdings indicating a relatively low level of concentration risk.

In terms of individual holdings, Toyota Motor Corp takes the top spot while Mitsubishi and Soft Bank occupy the second and third position respectively. Among sectors, Consumer Discretionary, Industrials and Financials are given the top three spots. The fund charges an expense ratio of 50 basis points a year.

EWJ has returned over 8% in the past one year though the fund has lost about 1.2% so far this year (as of August 25, 2014). EWJ has a Zacks ETF Rank #3 (Hold) with a moderate risk outlook.

Japan Small Cap Fund (DFJ)

For better access to the core Japanese markets, investors can look to invest in small cap securities of Japan through DFJ. This is best suited for Japan-focused investors seeking to invest in dividend paying small cap firms (read: Small Cap Japan ETFs: Overlooked Winners?).

DFJ is the most liquid small cap fund with the highest trading volume and assets under management in the small cap space. The ETF invests about $313.6 million in 588 small-cap securities. Industrials, consumer discretionary and materials enjoy the top-three allocations in the fund.

The fund is equally weighted and does not bear concentration risk. The fund charges a fee of 58 basis points annually. DFJ has added about 5.5% in the year-to-date frame while it returned about 12% in the last one year. DFJ has a Zacks ETF Rank #3 with a moderate risk outlook.

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Read the analyst report on DXJ

Read the analyst report on EWJ

Read the analyst report on DBJP

Read the analyst report on DFJ


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